Working Paper: NBER ID: w18270
Authors: Craig B. Merrill; Taylor D. Nadauld; Ren M. Stulz; Shane Sherlund
Abstract: Much attention has been paid to the large decreases in value of non-agency residential mortgage-backed securities (RMBS) during the financial crisis. Many observers have argued that the fall in prices was partly driven by decreased liquidity and fire sales. We investigate whether capital requirements and accounting rules at financial institutions contributed to the selling of RMBS at fire sale prices. For financial institutions subject to credit-sensitive capital requirements, capital requirements increase as an asset's credit becomes impaired. When accounting rules require such an asset's value to be marked-to-market and the fair value loss to be recognized in earnings, a capital-constrained firm can improve its capital position by selling the credit-impaired asset even if it has to accept a liquidity discount to do so. Using a sample of 5,014 repeat transactions of non-agency RMBS by insurance companies from 2006 to 2009, we show that insurance companies that became more capital-constrained because of operating losses (uncorrelated with RMBS credit quality) and also recognized fair value losses sold comparable RMBS at much lower prices than other insurance companies during the crisis.
Keywords: capital requirements; fair value accounting; fire sales; mortgage-backed securities
JEL Codes: G22; G28; G32; M41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| capital requirements and fair value accounting rules (G28) | capital-constrained financial institutions sell RMBS at fire sale prices (G21) |
| negative operating cash flows (G32) | capital-constrained financial institutions sell RMBS at lower prices (G21) |
| PC insurance companies (G22) | more likely to sell RMBS than life insurance companies (G22) |
| PC firms with below-median regulatory capital (G28) | significantly more likely to sell RMBS (G24) |
| sales by constrained firms (D22) | larger price discounts for low-quality assets (G19) |
| capital constraints (D24) | incentives to sell low credit-quality assets at discounted prices (E44) |